Institutional Investors and Corporate Governance - Essay Example

al Investors and Corporate Governance Introduction According to the OECD report on the influence of al investors in corporate governance, a high level of global assets under management are operationally controlled by the traditional institutional investors – more actively by the pension and mutual funds, and more passively by the insurance companies. It is estimated that in 2009, the total financial assets managed by institutional investors worldwide exceeds US$ 53 trillion, of which US$ 22 trillion of which is in equities. The implication is that company oversight, as well as the entire corporate governance system, will depend on the degree to which institutional investors make informed use of their shareholder rights and effectively exercise their roles as corporate owners.1 The role of institutional investors as overseers of corporate health and regulatory compliance has been drawn into sharper focus as a result of the financial crisis in 2008. The concern is that deficiencies in the monitoring of institutional shareholders have led to a quality of oversight far below that which is required, being reactionary and passive in the exercise of their voting rights. They are perceived to be ineffective in challenging boards, relegating their decisions to proxy advisers or alternatively constraining management to decide in favour of short-term financial profits at the expense of more prudent long-term benefits. This study conducts an inquiry into the academic literature on the role currently played by institutional investors in corporate governance. The study may provide insight into the control and accountability procedures in the large domestic and foreign corporations, since these are the entities which cause the greatest damage in every global financial crisis. Defining corporate governance Corporate governance is ‘the system of laws, rules, and factors that control operations at a company.’2 It has developed into a major area of concern because potential conflicts of interest (otherwise known as agency problems) tend to arise among stakeholders in the corporate structure. It generally assumes the inevitability that ownership and control are separate in public corporations, where management which exercises control over operations acts as agents of the owners or shareholders. Agency problems tend to arise from two sources: (1) the differences in the goals and preferences among the stakeholders; and (2) the lack of perfect information among stakeholders about each other’s knowledge, actions, and preferences. Corporate governance consists of the set of structures that define the boundaries for firms’ operations. Among the factors influencing corporate governance are the board of directors, laws and regulations, labour contracts, the competitive environment, and the market for corporate.3 The board of directors is the significant driver of internal control in the governance of the corporation because it has the right to hire, fire, and compensate managers. The party which drives the external control mechanism of corporations, however, would be the institutional investors who own equity in the corporation. In light of the recent financial crisis, institutional investors are gaining increasing importance due to what is perceived to be the failure of the board of directors to maintain sufficient internal control over the corporation. The effectiveness of their control, however, is still a matter of debate due in part to the difficulty of isolating and identifying those changes in corporate conduct that are attributable directly to the workings of the institutional shareholders. The formulation of corporate governance guidelines is the means by which a firm may seek to reduce agency costs (the consequences of the separation of ownership and control). Agency costs come in the form in the cost of hiring management personnel, and from costs incurred due to divergence in the acts of management from the wishes and interests of the owners of the business. Institutional shareholders are seen to have the power and resources to create sufficient pressure on management to pursue the interests of shareholders and ascertain that management’s actions are compliant with the law and regulations.4 Figure 1: Socio-political view of corporate governance5 The foregoing figure illustrates the paradigm by which corporate governance may be viewed in its socio-political context. The firm’s direct stakeholders – the board of directors, owners, suppliers, managers, employees and consumers – have separate, different, and sometimes conflicting demands upon the firm, and in addressing them the firm works within the limitations and constraints imposed by the capital markets, the legal structure, the labour markets and the product markets. Legal governance describes the regime by which the firm is able to meet all of these demands upon its operations in a fair and transparent manner, so that the interests of the different shareholders are equitably served, without any one party being unduly favoured at the unfair expense of the others. The global perspective on corporate governance and institutional investors The global economy has enabled the proliferation of multinational corporations that operate in several continents and across several legal jurisdictions. The corporate governance of these MNCs are therefore of great interest to the global institutional investors; however, they are then also hampered by the different regulatory regimes encountered in the different countries where they or the MNCs have a presence. In response to the evident need for a standard and commonly enforced guideline, international bodies such as the Organization for Economic Cooperation and Development (OECD)6 and the European Commission (EC)7 have taken steps towards the creation of just such a common Code or set of Guidelines. The fundamental differences in between national regulations are attributable to the variability in the conditions pertaining to each country. The following figure is derived from the database of the Organization for Economic Cooperation and Development, or OECD. It shows the variability in the composition and structure of shareholders in the major corporations in each of five countries at two points in time, to gauge the changes that have taken place in ownership structures. Evident in the figure are the differences in the changes of ownership composition. For Australia and the US, there has been little change in 20 years, but for Japan and the UK there have been significant increases in the proportion of foreign shareholders and the commensurate reduction in the proportion of other investors. Increase in foreign investors is likely due to the liberalization of investment policy, but it is also indicative of the greater trust and confidence reposed by cautious foreign investors in the companies, and the perceived reduction in the risks of investing in these countries due to improved corporate governance. Figure 2: Ownership structure in selected OECD countries8 The next figure similarly shows the comparative figures depicting the proportions of assets managed by institutional investors in the country’s corporations. The greatest jump in proportion of assets under institutional investor control is those of investment funds, followed by insurance corporations and autonomous pension funds. This represents a move towards non-traditional, more active management of assets, and suggests that institutional investors are taking a more active role in the oversight of the corporations they nvest in, among the OECD member countries. Figure 3: Financial assets under management by institutional investors in OECD countries9 In order to harmonize the differences between European Codes, the EC has released its guiding principles, particularly in the matter of remuneration policies in the financial services sector.10 Corporate governance and ownership structures in the UK In a report11 by the Head of Corporate Governance, Institute of Directors in the UK, the UK model of corporate governance is fundamentally different from the legislative-based approach of the US. The UK framework developed over the last two decades is grounded on board engagement with shareholders and compliance with a voluntary code of best practice. The framework revolves around the Combined Code and the ‘comply or explain’ principle, as practised in the UK, is increasingly emulated by policy makers in other countries because of its flexibility in promoting high corporate governance standards without unduly restricting the wealth creation process.12 The table shown below page provides a sense of the distribution of ownership among corporations in the U.K., comparing between corresponding proportions in 1963 and in 2004. In the 40 intervening years, there is a significant rise in the proportion of ownership accounted for by foreign capital (from 7% to 33%), and a corresponding fall in the proportion of ownership attributed to individual investors (from 54% to 14%). The figures point to a greater equity participation, and therefore the more active involvement of the institutional investors represented by foreign capital, insurance companies and pensions funds, in the governance of publicly listed companies. Table 1: Types of ownership in the UK in percentages13 Type of ownership 1963 2004 Foreign capital 7.0 32.6 Insurance companies 10.0 17.2 Pension funds 6.4 15.7 Individuals 54.0 14.1 Unit trusts 1.3 1.9 Investment trusts 11.3 3.3 Other financial institutions - 10.7 Charities, churches, etc. 2.1 1.1 Private non-financial companies 5.1 0.6 Public sector 1.5 0.1 Banks 1.3 2.7 The determination of executive compensation There are six elements in executive compensation: base salary, bonus, stock options; restricted share plans or stock grants, pension, and benefits (including car, healthcare, and so forth). According to the Combined Code on Corporate Governance 2008, ‘there should be a formal and transparent procedure for developing policy on executive remuneration and for fixing the remuneration package of individual directors.’14 The matter of executive remuneration is easily the most contentious of the issues facing institutional shareholders and corporate governance regulators alike, according to a survey of institutional investors managing $2 trillion in assets.15 Mallin16 identified four areas where the debate on compensation tends to focus: (1) the overall level of directors’ remuneration and the role of share options; (2) the suitability of performance measures linking directors’ remuneration with performance; (3) the role played by the remuneration committee in the setting of directors’ remuneration; and (4) the influence that shareholders are able to exercise on directors’ remuneration (p. 189). The setting of remuneration is an issue that tends to cross borders although different laws and regulations govern in different countries. Particularly in the case of multinationals, the system of setting remuneration packages, reward and incentive systems influences the decision of prospects for top level positions, and at that level of multinational operations a relatively limited and commonly-shared pool of prospects is shared among the conglomerates, so the setting of remuneration is influenced by the market and competitors tend to seek to match each other’s bids. Between the US and the UK in particular, long-term pay and incentive offering in the US tends to influence the same in the UK.17 The setting of remuneration therefore has become an issue of debate in the study of cross-border contagion that takes place during financial crises. Hartzell and Starks18 sought to determine the impact of institutional ownership on the treatment of executive compensation, through a database search of publicly listed companies. Their study regressed pay-for-performance sensitivity and the level of executive compensation as dependent variables, and concentration of institutional investor ownership as independent variable. The study found that the concentration of institutional investor ownership relates positively to the performance sensitivity of managerial compensation – otherwise stated, when a greater proportion of company shares is owned by institutional investors, executive compensation relates more closely to the performance of the company. Another finding is that changes in institutional concentration are also positively related to subsequent changes in incentive compensation; however, the reverse is not true, i.e. changes in executive compensation do not influence the institutional concentration. It was also averred that on average, institutional investor monitoring used in combination with incentive compensation can mitigate much of the agency problems that normally take place between management and shareholders. These findings support the proposition that the presence of institutional investors serves to link executive compensation to the actual company performance. Another study was conducted by Strivens, Espenlaub and Walker,19 on the relationship between institutional shareholdings and CEO cash-based remuneration. Their findings included five significant empirical regularities: (1) Controlling for firm size, the presence of a large institutional shareholding or alternatively a high concentration of institutional shareholdings reduces significantly the magnitude of executive salary and bonuses; (2) institutional shareholdings significantly increases the positive relationship between bonus remuneration and firm performance; (3) The presence of a large institutional shareholding, or high concentration of institutional shareholdings reduces the rates of increase in salaries, benefits and bonuses; (4) The magnitude of salary and benefits are negatively related to firm performance, suggesting that regardless of whether their firm performs satisfactorily or not, CEOs are taking their contract salary; and (5) Salaries and bonuses should be modelled separately since they are paid during different time periods and for different reasons, therefore abiding by the standard practice of modelling them together leads to false outcomes.20 The study therefore confirms the findings of Hartzell and Starks, that companies with significant participation of institutional investors generally pay their CEOs commensurately to the performance of their companies. The phenomenon of poor value executive remuneration is one that is seen to affect American and British companies significantly more than other countries in the world. Sykes21 underscores the serious crisis of confidence and loss of public trust in large corporation in the US and UK, mainly due to the disparity seen between corporate performance and executive salaries and bonuses, and traces the cause of this phenomenon largely to conflicts of interests among large corporate executives. The underlying weakness is the failure of the system of governance to call these executives to account to those whom they serve, the shareholders and stakeholders. Executive accountability to both individual and institutional shareholders, represented by the fund managers and agents, is both limited and delayed; additionally, the agents and fund managers are likewise delayed and lacking in accountability to the ultimate beneficiaries, the fund members and policyholders, a situation which compounds the problem and allows for self-interest free rein. There are several specific causes of inappropriate executive remuneration: (1) Lack of independence of remuneration committees. In major US and UK companies, he remuneration committees are comprised largely of non-executive directors, purportedly to ensure the independent determination of senior management pay. What is not readily apparent, or intentionally overlooked, is that the selection of the non-executive directors are done by, or with the full agreement of, senior management, making the selected individuals beholden to those who had chosen them and constituting a grave conflict of interest.22 (2) Remuneration consultants chosen by management. Conflict of interest also arises when corporate management chooses the consultants to the remuneration committee, who provide advice on executive pay, bonuses and related matters. They are often the same advisers to the managers on compensation within their own companies, and by this token are perceived to have ties of loyalty to these same managers. Certainly, it is difficult to imagine these consultants advising against the pay raises of those who have selected them, or to recommend a reduction because their pay levels are already too high. 23 (3) Mismatch between period of remuneration incentive and underlying shareholders. Managements are expected to perform within an unrealistically short tenure, presently averaging only four years and further trending downwards. This creates a gap between the investment horizon of shareholders, and the performance duration of management. It also enables managers to avail of no-risk stock options which now comprise the main component of most executive remuneration. Coupled with this is the tendency of management to adopt short-term measures that tend to increase stock prices abnormally in the short-term, enabling managers to cash in at high levels while still on the job. (The the minimum allowable period for selling stock options which is 3 years in the UK and shorter even in the US). In contrast, shareholders normally have a long-term investment horizon spanning the years until their retirement.24 The short-term orientation of CEOs to show immediate results within their brief stay, and the long-term orientation of shareholders in general, creates a conflict of interest in management between making quick fix decisions over actions that may be more painful in the near terms but which engender stability and sustained growth in returns over the long run. (4) Absence of correlation between firm performance and executive remuneration. The matter of executive compensation is probably the most generally perceived issue on corporate governance.25 Although more recent studies, such as those encountered in this literature review, tend to qualify this correlation or absence thereof where institutional investors are concerned the general observation still leans towards lack of a link between performance and pay. (5) Inappropriate earnings criteria. Management performance used to be judged in terms of financial performance where the basis for evaluation is usually the pre-tax earnings or EBT of the firm. More recently, management has come to project its performance in terms of gross earnings, which is the total revenue turnover prior to deductions for costs of production and relevant expenses.26 As a result, accountability for their performance overlooks the internal inefficiencies of their firms’ operations and, more importantly, it allows the management to project stellar earnings without regard for the end results to the shareholders who may actually be incurring a loss. Problems and limitation in institutional participation in corporate governance There have been various shortcomings in the corporate governance framework that have rendered institutional investors less than effective in exercising proper control over the companies they invest in. Webb, Beck and McKinnon27 bought into question the wisdom of increased institutional investor participation in corporate governance. They reviewed the series of governance codes which have been introduced into the UK the purpose of which is to pressure publicly listed companies to observe practices deemed prudent in their overall operations. One such code, the Hampel Code,28 called in particular for the increased role of institutional investors in resolving governance issues without requiring the introduction of a mandatory regulatory framework. The paper used financial system theory as a framework for disproving the usefulness and efficacy of assigning the duty of guardianship to institutional investors. Hampel and similar codes are doomed to failure because of the following: (1) The proposed code is premised on the grounds that the market is efficient enough to price assets correctly. This presupposes perfect information, that is, all relevant information is known to all participants at the same time, and they have assessed it in exactly the same way to yield the same opinion. However, the market is seldom this efficient, and even if institutional investors have the right information, they would in the meantime be trading on this information (which is what an investor does) so as to materially alter in the meantime the market dynamics surrounding the value of the information and causing the asset prices to change. Therefore, the Hampel Committee’s expectation – that the institutional investors will prioritize the corporate governance concern of the corporation prior to their own portfolio management – is not consistent with the realities of market behaviour. (2) The second assumption of the Hampel Report is that institutional investors will tend to be more involved in running the daily operations of the companies they invest in. This is inconsistent with the nature of institutional investing, which is to remain liquid and increase, reduce or divest their positions in certain companies depending on their fundamental indicators. (3) Finally Hampel makes the questionnable assumption that investors are not empowered to determine the strategic directions of the company, therefore there is little incentive for such investors, moreso institutional investors. The lack of incentive and involvement in the goal-setting functions of the business naturally and predictably results in a lack of concern and involvement in the operational and tactical management of the firm. In order for an investor to influence company strategy and to exert pressure on companies to adhere to principles of corporate governance, the investor will have to acquire an influential shareholding (i.e., a certain percentage holding, usually 5% or more of total shares, in the company that will entitle and investor to a board seat). Needless to say, many institutional investors will find this too costly and would rather opt to divest. (4) Such a regulation that places a mandatory duty upon institutional investors do not lend themselves to the imposition of sanctions in case the duty is not complied with. Furthermore, imposing a duty for institutional investors but not for individuals creates an inconsistency under the law, and violates the principle of equal protection which is a requisite under the law. Conclusion The empirical evidence encountered in this research point to the confirmed existence of an inappropriate and even scandalous disregard for firm performance in enforcing accountability upon executives. This causes an inequity in the balance among the different shareholders discussed at the beginning of this paper. When the interests of top management is catered to at the expense and even to the detriment of the other stakeholders, and most especially the value to the shareholders, then corporate governance has failed. Since board of directors appear ineffective in the internal control of the firm, the prevailing wisdom is to turn to institutional investors to enforce external control over executive management. There are encouraging findings that lead to the validation of the role of institutional investors in instilling a measure of accountability and governance in the corporation, but this is at best a matter of volition and consensus rather than an enforceable mandate. The establishment of a mandatory code necessitates the formulation of assumptions that are implicit in codes such as Hampel, which however meet serious issues when sought to be implemented. The assumptions meet no strong objections on a theoretical basis, but they exhibit a remarkable naivete in the matter of the predicting investor behaviour in relations to the workings of the stock market. There is real concern that institutional investors could sustainably maintain the role of overseer and protector of the public interest. Firstly, institutional investors do not have authority to control company operations, and could not be under any framework be held answerable for the firm’s eventual failure to observe the due standard governance. Secondly, and more importantly, the institutional investor, like any other investor, is not primarily committed to the general public but to its own shareholders/fund members, and will in the first serious sign of corporate failure, trade off the unfavourable stock before blowing any whistles on the company underlying it. Still, there is much that institutional investors can contribute to pressuring management to comply with corporate governance guidelines, as empirical evidence point out. Any role ascribed to institutional investors in this regard should be consistent with their primary duty of serving their members and shareholders first. This precludes any formal or statutory obligations that government or other regulators may think to straddle institutional investors with, as it will inevitably create their own conflict of interest dilemmas and failure of corporate governance. In the end, all that can be said is that balance and equilibrium must be maintained among all interests concerned, institutional investors included. References Aguilera, Ruth V., Cynthia A. Williams, John M. Conley, and Deborah E. Rupp. 2006. "Corporate Governance and Social Responsibility: a comparative analysis of the UK and the US." Corporate Governance: An International Review 14, no. 3: 147-158. 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"Problems and Limitations of Institutional Investor Participation in Corporate Governance." Corporate Governance: An International Review 11, no. 1: 65-73. Business Source Complete, EBSCOhost (accessed April 15, 2013). Read More